When economies expand, it is tradition for stocks to outperform bonds. However, this is not traditional times and over the past 30 years bonds have been outperforming stocks. A major reason bonds have done better is that since 1982 government bond yields have been declining.

Traditionally, when economies expanded stocks outperformed bonds; but these aren’t traditional times and although economies have expanded, over the past 30 years bonds have outperformed stocks.

Since 1981 the return on long-term government bonds averaged 11.5 %. The S&P stock index averaged 10.8 %; and, since 2000, the returns of stocks over bonds have widened. A major reason why bonds have done better is that since 1982 government bond yields have been declining; and when bond yields decline, bond profits rise.

From Dec. 31, 1999, through May 29, 2012, the Barclays Capital U.S. Aggregate bond index - which covers the investment-grade bond market, including government and corporate bonds as well as mortgage- and other asset-backed securities - returned 104.1 percent to investors. By comparison, the total return of the S&P 500 was 14.2 percent, including share price gains and dividends.

With bond investing, the basic principle is that interest rates and prices move in an inverse relationship. When interest rates went from 4.78% to 6.75%, that represented an increase in yield of over 40% [and] the price of the bond declined by a corresponding amount. On the other hand, when interest rates decline, then the price of the bond goes up.

Today, with bond yields near zero, yields can’t go much lower which means bond profits can’t rise as they once did. Yet, despite today’s outlook for lower bond profits, investors are increasingly buying bonds, not for profit but for safety.

INVESTORS ARE SPOOKED, RISK IS BACK IN TOWN

In January 2008, in The Economy and the Fat Kid, I wrote:

… one day, a fat kid shows up at the playground. While everyone knows it’s a private playground and admittance is strictly controlled, no one knows where the fat kid came from or how he got in. Nonetheless, the fat kid’s there.

Then the fat kid walks over to the teeter-totter and sits down. The fat kid’s end of the teeter-totter slams to the ground as the other end skyrockets up; tossing all those on the high end off. The name of the fat kid is risk.

DON’T BLAME THE FAT KID: THE ROLE OF RISK IN FREE MARKETS

…Between 2002 and 2007, risk went into hiding as central banks flooded the markets with cheap money; allowing capital flows to mask losses while boosting asset values to record levels. Billions of dollars of central bank credit translated into trillions of dollars of leveraged bets creating bubbles in all asset classes—real estate, stocks, commodities, and bonds.

… But global market risks, temporarily hidden by cheap credit, have now reasserted themselves with a vengeance… Risk is back and no matter how often the playground supervisor tries to reassure us, we know the playground is no longer safe. Even the big kids are getting hurt. The fat kid’s back and so is the whiff of deflation.